2023-11-22 12:06:56 ET
Summary
- RTX Corporation stock gained more than 8% since September, with changes to shareholder returns.
- The GTF turbofan program is facing difficulties, but the long-term value is expected to be significant.
- Collins Aerospace and Pratt & Whitney segments performed well, while the Raytheon segment had lower sales growth.
- The company has a massive backlog with positive demand trends in its end markets.
In September 2023, I analyzed RTX Corporation ( RTX ) stock and marked the stock a buy based on the significant plunge in stock price, which I believed was not proportionate to the issues faced on the GTF turbofan program. Indeed, the program is facing significant difficulties which will ground on average 350 airplanes per year through 2026. However, for the longer term, I believe this program will be a significant value driver for RTX due to a growing installed base and continued servicing required for engines which tend to have an escalating pricing nature for spare parts. Since my report in September, the stock has gained more than 8% with some changes to shareholder returns, and in this report, I will be discussing what this does to the valuation of the company as well as a brief look at the earnings to start.
A Brief Discussion Of RTX Geared Turbofan Costs
In my previous report, I already did a sanity calculation to assess whether the revenue charge and cost charge were excessive because that's what was suggested. Back then my calculations showed that for the additional engines that were brought under the scope of inspection costs were not excessive.
Estimate and recognized charges for GTF Turbofan Issue in $ millions | |||||
Line item | My estimate | RTX Estimate | Reported | Difference | Comment |
Sales Charge | $ 5,625 | $ 5,500 | $ 5,400 | -4% | Lower than estimated |
Profit Charge | $ 2,869 | $ 3,000 | $ 2,900 | 1% | In line with the estimate |
If I look at my estimate, the estimate from RTX provided in September, and the reported figures we see the charges were more or less in line. I had expected a sales charge of $5.6 billion. RTX had estimated $5.5 billion and the charge ended up being $5.4 billion which was 4% lower than my expectations and 1.8% lower than what RTX had previously guided for. The charge on the operating profit level came in as expected and my estimate was actually closer to the reported figure than what RTX had previously estimated. So, we saw no surprises in the recognition of the costs for the GTF debacle.
RTX Earnings Review For Q3 2023
The problems with the GTF program are a major inconvenience for RTX, customers, and GTF suppliers. However, just by looking at the sales and profit charges you might be missing the bigger picture. Therefore, it's also important to consider the adjusted figures and keep in mind what the performance in the businesses other than Pratt & Whitney (which includes the troubled GTF) was.
Collins Aerospace saw sales increase 17% driven by strong growth in commercial aftermarket sales and commercial OEM sales which were 30% and 27%, respectively, showing that the increase in commercial aerospace sales is no longer solely driven by service and spare parts demand. Military sales were down 1% due to timing of deliveries. Important to note is that, sequentially OEM sales grew 27%. All of that resulted in 38% higher operating profit while higher production costs and general expenses were also part of the cost mix. So, the Collins Aerospace segment did very well.
Pratt & Whitney adjusted sales were up 18% and again we see that commercial OEM and commercial aftermarket sales were leading the way and the F-35 sustainment and development lifted military revenues. Again, despite higher costs we saw 30% increase in profits and an expansion in margins.
While Collins and Pratt & Whitney are performing well, the story is different for Raytheon. The company has a $50 billion backlog which linearized would fill roughly two years worth of revenues, but its sales growth of 3% does not compare favorably with for instance the growth seen in commercial or military engines, but it's also in the nature of defense businesses. Furthermore, the company sees the general cost pressures which are particularly painful on fixed-price contracts which do not account for higher costs for instance driven by higher raw material costs, labor or inflation.
Will RTX Climb Back To Previous Highs?
The big question is of course whether RTX can climb to previous highs. As a reference, the 52-week high is $104.91. So, RTX stock is trading 25% off its 52-week high. So, those are big declines measured from the top. However, I also would point out that from the highs we saw in February and the highs we saw during the past 52 weeks, there have been a lot of moving items. The pandemic eroded demand for airplane manufacturing and servicing and I would say we're not even at the point where production should be and that might not happen for another three years or so. All commercial airplane programs are expected to go up in production rate and that should be beneficial to Collins but also to Pratt & Whitney. Indeed, the Geared Turbofan issues are a pain and according to the CEO of Park Aerospace, the share of CFM LEAP 1A orders has increased to 66% on the back of the recent issues with the GTF. How painful is that?
Currently the production rate for the Airbus A320neo is around 45 airplanes a month which would mean around 20 airplanes rolling out of the Airbus assembly sites are equipped with GTF turbofans. Even if we model in the market share growth of CFM against the GTF coupled with production rate targets of 75 airplanes per month for the Airbus A320neo, the number of GTF deliveries could go up to 25-26 per month which means that there are 30% upside to the Pratt & Whitney deliveries which still provides a multi-decade revenue stream, and one can wonder whether over a multi-decade span the market share loss we're seeing now will last.
Furthermore, we're seeing bookings for defense exceed revenue generation by 17% and I believe we're at the early innings of a big multi-year wave of significantly higher defense spending, and all of that should translate well to the RTX defense business.
So, there are pressures for Pratt & Whitney and there are pressures for the defense business, but generally, the multi-year trends are providing opportunities to generate real value with sustained growth opportunities, and I would expect that would help the company get back to its previous highs.
RTX Expands Stock Buyback Plan
So, just looking at the demand trends in end markets I would say there's a lot to be positive about and I think management has also realized this as they announced an accelerated share repurchase program of $10 billion which allows it to buy back around 8.8% of its stock.
Will RTX Stock Go Back Down?
Since I wrote my report, RTX stock has appreciated about 8.2% and around 6.7% since the announcement of the accelerated share repurchases. So, you could say that a significant portion of the buyback has been priced in but the ongoing recovery in primarily the commercial OEM and services results has not, let alone the upside in the longer-term trends for commercial that should yield growth in the back half of this decade as well as steady growth for defense on better contracting terms. With that in mind, I don't think that RTX stock will go back down. I can't predict the market but I would not consider a negative stock price trajectory to be in line with the upward trends in the end-markets. It should be noted that the company is financing the buyback with short- and long-term debt so that's something to keep in mind. I'm generally not a fan of buying back stock with borrowings, but I think if you look at the upward potential for the business that this might turn out to be a prudent decision by management over the longer run.
Is RTX A Good Stock To Buy Now?
The big question of course is whether RTX stock is a buy or not. To answer that question, I have updated the balance sheet information, EBITDA estimates and free cash flow estimates for RTX Corp. Moreover, I'm also implementing the proceeds expected for the sale of the Collins Aerospace actuator business to Safran SA ( OTCPK:SAFRF ) which should generate $1.8 billion in proceeds and the sale of the Cyber business at $1.3 billion. These divestments are all modeled to be completed in 2024 with the decrease to EBITDA also being accounted for.
The final change will be the implementation of the $10 billion stock repurchase program which we have modeled as a decrease to the share count and a concurrent increase to debt. Early in November, the company issued Notes and agreed on loans in the total amount of $10 billion which was used to pay off the earlier bridge loan agreed on in late October for the share repurchases.
Changes to EBITDA:
Changes to EBITDA in $ millions | ||||
Year | Previous | New | Change | Change [%] |
2023 | $ 12,934 | $ 12,605 | $ -329 | -2.5% |
2024 | $ 14,155 | $ 13,696 | $ -459 | -3.2% |
2025 | $ 15,217 | $ 14,954 | $ -263 | -1.7% |
Total | $ 29,372 | $ 28,650 | $ -722 | -2.5% |
In total, there's an expected pressure of 2.5% related to accrual expenses for the GTF program and the divestments based on analyst expectations compared to my previous expectations.
Changes to Free Cash Flow Estimates:
Changes to FCF in $ millions | ||||
Year | Previous | New | Change | Change [%] |
2023 | 4284 | 4728 | $ 444 | 10.4% |
2024 | 5362 | 5253 | $ -109 | -2.0% |
2025 | 6894 | 6997 | $ 103 | 1.5% |
Total | $ 12,256.0 | $ 12,250.0 | $ -6 | 0.0% |
Compared to the previous expectations. There is some variability in free cash flow per year, but overall my initial expectations fetch rather well with updated analyst estimates.
Perhaps a more prominent change to the valuation that could possibly offset any positive impact from the share repurchase program is the fact that we have upgraded the stock valuation tool that now more accurately follows cash flows.
For those who followed my previous valuation of RTX Corporation stock, you might notice that despite the $10 billion share repurchase program the price target has not moved much. In fact, the stock price is roughly a dollar lower which I would attribute to the share repurchases being financed with debt and the stock valuation tool more accurately describing the cash flows. Beyond that, I foresee additional borrowing needs in the years to come.
That, however, does not mean that I'm less optimistic about the stock. Valued in line with its peers there's 41% upside to $110 which closely coincides with the high target that Wall Street analysts have for the stock. As mentioned in my previous report, I'm not convinced that a 16x EV/EBITDA valuation that I use for aerospace and defense stocks is fully justified for a company that's going through its fair share of problems. At the same time, the 8.05x EV/EBITDA valuation is very low. Things are bad for RTX, but not that bad that we should value it in line with airlines. The company simply holds too many positive elements for that. So, using a multiple expansion that will close 50% of the valuation gap between the targeted industry multiple and the company median EV/EBITDA, I get to a $82.67 price target representing 5.7% upside. Generally, I'm looking for upside of at least 10%. However, I do believe that the longer-term trends warrant a buy and the automatically generated rating in the screenshot of the valuation tool is in agreement on that. The reason why I personally think the company is a buy is that the current repurchases, although financed with debt, allow for even better shareholder returns in the form of dividends, and once the company has sorted its issues and perhaps if a bull market of some sort we could see RTX trade closer to peers which would unlock double-digit upside from current levels. So, there are many moving items to be positive about.
Conclusion: RTX Stock Remains A Buy For Me
The GTF issues are of course ugly for RTX and it hurts the credibility of the platform and business, but the cost and sales charges have already occurred, and from here on we will see the cash flow pressures materialize but even with those cash flow pressures there's significant upside as the company's median EV/EBITDA is out of line with that of peers, and I think it insufficiently appreciates the long-term trends and demand drivers active in the end markets for RTX Corporation. So, by focusing too much on the near-term pressures and the pressures on the GTF program investors might be missing a golden opportunity. That's not to say that RTX is performing flawlessly because the Raytheon segment results in Q3 2023 for instance were not great, but the company overall showed strong results despite higher input costs and going forward the company will likely also be more diligent on accepting fixed price contracts which should make its future bookings and a significant part of its current $50 billion backlog more worthwhile.
For further details see:
RTX Stock: A Buy After Post-Earnings Rally